Lord Nigel Lawson: Five Myths and a Menace

This is the inaugural Adam Smith Lecture given by Lord Nigel Lawson, the former Chancellor of the Exchequer, at Pembroke College, Cambridge, UK on November 22, 2010.
I wonder whether enough has been made by Adam Smith scholars, which I do not claim to be, of the intellectual connection between Smith and Charles Darwin. Darwin himself records how, during his last year at Cambridge, he spent much of his time studying Smith. And I have long been struck by the parallel between Smith's explanation of how economic order and growth is secured by the free interaction of individuals seeking their own personal satisfaction, "as if by an invisible hand", and Darwin's revolutionary insight, a century later, of how the remarkable natural order could arise spontaneously as a result of natural selection, without the need for an intelligent designer or divine watchmaker.

Be that as it may, I have been toiling in the field of political economy — and how refreshing it is to see the revival of that almost obsolete but wholly accurate term — for the best part of half a century now, first as an observer of policy-making as a journalist, starting on the FT in the 1950s, and for the past 36 years as a politician and sometime minister, as both a close observer and a practitioner.

Throughout that time, I have found both Adam Smith's insights and his approach to the subject, however distant in time, both convincing and congenial. Not that I was brought up on him. My economics tutor at Oxford (I specialised in philosophy, but I did do some economics) was Keynes's pupil and first biographer, the endearingly eccentric Roy Harrod. Keynesianism ruled the roost, and Smith was known, to the extent that he was known at all, as the author of two books, one — The Wealth of Nations — of purely historical interest, and the other — The Theory of Moral Sentiments — of no interest at all. But I discovered him, to my instruction and delight, myself, and I hope the themes of this article are in his spirit. (I have borrowed my title from the film Four Weddings and a Funeral.)

Myth No.1

Myth number one is that economics is a science. It goes back quite a way. Economists, at least since Marshall, have mistakenly sought to dignify their calling by describing it as a science, and increasingly chosen to add verisimilitude to this pretence by clothing their propositions in the language of science, that is to say, mathematics. But economics is not a science. On scientific matters we rightly expect a high degree of certainty, and are ready to leave many important decisions to properly educated experts. By contrast, economic policy is more like foreign policy than it is like science, consisting as it does in seeking a rational course of action in a world of endemic uncertainty.

Perhaps that is why I increasingly found economic history, which is scarcely taught at our universities, and then inadequately, to be a more useful guide to economic policy decisions than economic theory, which is taught to excess. Meanwhile, the problem has become worse with the emergence of modern finance theory, which — although not responsible for the disastrous folly of so many of the world's bankers in recent years — undoubtedly encouraged them to indulge in it. By "modern finance theory" I refer to the combination of the efficient market hypothesis and the rational expectations hypothesis, which enabled mathematically inclined economists to provide the banks with computer models based on mathematical equations which effectively purported to take the uncertainty out of risk assessment.

It is true that markets are less inefficient than any other form of economic organisation, and that expectations are on the whole rational most of the time. But to derive the mathematical equations and construct the computer models it is necessary to assume total efficiency and total rationality, which is absurd. Economics, after all, is about human behaviour. The notion that you can adequately capture human nature in a series of mathematical equations is inherently ludicrous. Yet that is the premise of modern finance theory, on which bankers chose to rely, to their — and even more, our — cost.

Mathematical economists contend that in any discussion of a system as complicated as the economy being exact in one's arguments is essential, and that mathematics is a language that can capture this precision. Indeed — and that's just the problem. Endemic uncertainty (whether Knightian or any other variety) makes the precision that exists in the physical sciences unattainable, and makes the illusion that it is attainable unwise and dangerous. Underlying the mathematical economists' position seems to be the assumption that there is no rational space between the certain and the random (or irrational). Not so. Not only is there such a space, but it is where public policy, whether foreign policy or economic policy, properly lies, and where history has to be our principal guide.

There is also the predictability test. That is how we decide between theories in the physical sciences. But human behaviour — whether in the economic or the non-economic sphere — although not wholly unpredictable, is not sufficiently predictable to make mathematical equations (although interesting) of any practical use. There is an understandable illusion that because economic outcomes, unlike (say) foreign policy outcomes, can be quantified, mathematical equations can be applied to the former area even though they are clearly inapplicable to the latter. But it remains an illusion, since the fact that economic outcomes can be quantified in no way mitigates the uncertainty that attaches to all areas of human behaviour, whatever they may be. Modern finance theory, and the mathematisation of economics of which it is a part, are both absurd and — as we have seen — highly dangerous. It may be helpful, from time to time, for economists to use mathematical models to assist in clarity of thought. The danger arises when they confuse their models with the real world. It is notable that the essence of Smith's approach to political economy in the Wealth of Nations is not scientific, let alone mathematical, but historical — informed, of course, by a profound and clear-sighted understanding of human nature.

Nothing I have so far said should be taken in any way as a denigration of science. The achievements of science have been, and no doubt will continue to be, greater than the achievements of economics. But what is at issue is the crucial distinction between the physical world and human behaviour. I realise that this is getting (in theory) dangerously close to the vexed question of free will — one of the few remaining philosophical problems not to have been either resolved by scientific understanding or dissolved by the exposure of linguistic muddle.

But in practice this is a non-issue. The plain man says: "I have to believe in free will: I have no choice"; and that is good enough for me. But I must say, en passant, that I am far from sure that the superiority of science (when it sticks to its extensive last) over economics is matched by a corresponding superiority of scientists over economists.

Certainly, nowadays, when it comes to public policy, scientists have come to resemble a new priesthood, intoning the orthodoxy of the day and seeking to cast out heretics, whereas economists appear to be in perpetual disagreement with each other, a somewhat healthier state of affairs however much it may dismay the policy-maker seeking informed advice.

Or, in the words of that wise economist, John Kay: "People who trained as scientists do not very easily think in terms of numbers and probability distributions. They cling to stories, and that is the way they proceed and that is the way they lead their lives. As an economist, I used to suffer from a kind of physics envy, but I have come to realise that as an economist I was probably better trained to think about controversial issues than I would have been if I had been a physicist."It is indeed remarkable that science, whose achievements were made possible by the enlightenment and the age of reason it brought forth, is far too often nowadays seeking to become a new religion, while it falls to economists in their modest way to cling on to the torch of reason.

Myth No.2

So to myth number two: that policy-makers should be guided by the precautionary principle. This can be disposed of rather more briefly, since — while a beguiling alliteration — on examination the so-called precautionary principle crumbles into meaninglessness. Insofar as it has any meaning at all, it oscillates between the precept "be careful", to which the correct response is "of course", and the precept "you can't be too careful", to which the correct response is "oh yes you can".

If you can't be too careful you would never travel by air, train or car. You would probably never even cross a road. According to Professor Lofstedt and Dr Fairman of the King's Centre for Risk Management, there are no fewer than 19 different formulations of the so-called precautionary principle — and none of them has sufficient precision usefully to inform policy decisions. This is perhaps unsurprising given that there are usually at least three dimensions of uncertainty. There is the assessment of the risk you might choose not to take, or at least to reduce. There is the assessment of the risk that you might be devoting substantial resources which might be better used in some other way. And there is the extent to which you are (or perhaps should be) risk-averse — something which is likely to vary from person to person and, perhaps even more, between different societies and cultures at different stages of development.

A slightly different approach is where the uncertainty involves what economists like to call "fat tails". This is something that has latterly preoccupied the eminent Harvard economist, Martin Weitzman. It arises where there are a range of possible outcomes, including an extreme outcome which, however unlikely, cannot be ruled out, and which — if it occurred — would be so catastrophic that, it is argued, there is no limit to what we should spend to reduce the risk. Professor Weitzman has written about this in the context of catastrophic global warming. But there are two great difficulties with this approach. The first is that there is not the remotest chance of securing global agreement on the proposed course of action. The second, and more fundamentally, is that, even if this could be overcome, there is a whole range of possible catastrophes that cannot be ruled out altogether.

Thus, in addition to catastrophic global warming, there are — to name but a few — the coming of a new ice age (as the distinguished Cambridge scientist, Sir Fred Hoyle, warned in his book Ice), a nuclear holocaust, the mother and father of all pandemics (or plagues, as they used to be known) or a large asteroid hitting the planet.

To which the current President of the Royal Society, Martin Rees, in his book Our Final Century? has added the risk of nanotechnology running amok and what he terms "bioterror or bioerror" from developments in biotechnology.

The problem is obvious: if we were to devote unlimited resources to guard against every conceivable "fat tail" risk, there would be nothing left for us to live on.

We have to use our common sense, based on our best estimate of probabilities — and, in particular, time scales, which Weitzman appears to ignore; since a threat of what might happen in a thousand years time is clearly less pressing than one that might occur in ten years time.

This, indeed, is what the recently published UK strategic defence review sought to do. But one thing is quite clear: the so-called precautionary principle is merely a term of advocacy, of no substantive meaning or use whatever.

Myth No.3

Myth number three is the notion, assiduously peddled by ministers in the present government, as it was by their predecessors, that policies to promote the replacement of carbon-based energy by substantially more expensive renewable energy, notably wind power, will bring great benefit to the British economy and in particular create millions of so-called "green jobs".

Now I have to confess that, having looked very carefully and thoroughly at the issue, I find the government's global warming policy intellectually incoherent — irrespective of the science, on which I keep an open mind. But even if the policy were justified, the claim that the promotion of renewable energy, whether by the provision of massive subsidies or by the prohibition of carbon-based energy, would have the added benefit of giving the economy a boost and creating millions of — or indeed any — additional jobs is economic illiteracy of the worst order.

To take the jobs issue first: as Adam Smith well understood, it is not the purpose of economic activity to "create" jobs. The purpose of economic activity is to satisfy the material needs and wants of the people. Or in Smith's own words, "consumption is the sole end and purpose of all production". As the great 19th-century French economist, Frédéric Bastiat, pointed out, if jobs are your yardstick, you might as well go round breaking windows so as to create jobs for glaziers. The history of economic progress has been not about the creation of jobs in any given sector but rather the dispensing with jobs, so that labour is released to meet new needs. It is known as increased productivity.

Indeed, the government's mantra is nothing more nor less than a revival of Luddism. The Luddites, it will be recalled, were concerned that the advent of mechanisation would lead to unemployment, as machines replaced men. So they smashed the machines in order, as they saw it, to preserve jobs.

The "green jobs" argument is no different. Both are variants of what economists call the "lump of labour" fallacy. In a reasonably well conducted economy — and I cannot believe that ministers believe that economic policy will not be reasonably well conducted by the present government and indeed by the Bank of England — there are, over time, jobs for virtually all those who wish to work. Hence the equilibrium or "natural" rate of unemployment.

So the question is one of where the jobs are. The government of the day can certainly influence that, most simply by enlarging the public sector of the economy. But what matters is how genuinely productive, in terms of meeting people's needs, any such employment is. And to return to wind power and all that, to engineer at great cost a switch from the production of relatively cheap carbon-based energy to very much more expensive renewable energy, may arguably be justified (although I disagree) on climate change grounds, but it cannot possibly be justified on either employment or broader economic grounds. There is the argument sometimes advanced that the world is fast running out of fossil fuels, so that we have to rely on renewables (and nuclear energy). That, too, is a myth, which I encountered when I was Energy Secretary some 30 years ago. But since it is not primarily an economic myth (although it does display astonishing innocence of both technological advance and the significance of the price mechanism) it does not belong here.

Why ministers insist on peddling the economic illiteracy they continue to espouse is something of a puzzle. Maybe they fear, perhaps rightly, that the British public will not buy into the global warming alarmist case for their policies, and that a spurious economic case might do better. But economic illiteracy is economic illiteracy, and to peddle it shows either lamentable ignorance or discreditable cynicism.

Myth No.4

So to myth number four, that Keynesian (or neo-Keynesian) stabilisation policy makes sense. Here again, Smith got it right. I have referred in the customary shorthand way to his Wealth of Nations. But the key to the right approach to political economy and government policy is to be found in the full title: An Inquiry into the Nature and Causes of the Wealth of Nations. What it is not called is An Inquiry into the Nature and Causes of Fluctuations in the Wealth of Nations; nor indeed is that its subject matter.

Yet it is this last that has been the mistaken obsession of economic and political commentators, and all too many economists, during my adult lifetime — not least at the present time, when the coalition government is being taken to task by the Keynesians for seeking to eliminate the structural budget deficit at a time when, although on the path to recovery, the UK economy remains weak.

The plain fact is that experience shows that the conduct of economic policy can have a profound effect, for good or ill, on the long-term prosperity of a nation and its people. Moreover, although the task is never easy, we also know from experience throughout the world, perhaps more clearly than at any time in the past, what the secret of success is.

By contrast, experience, not merely in this country, but throughout the developed world, demonstrates clearly that we cannot eradicate the business cycle, the alternation of boom and recession — although we do of course need to take steps to reduce the likelihood of a major banking crisis, which as we have seen can massively exacerbate the inevitable cyclical downturn.

Indeed, a case can be made for the proposition that what might be termed the normal business cycle confers benefits as well as incurring costs. Schumpeter was in a sense on to this with his theory of creative destruction. The superiority of market capitalism over all other economic systems lies in particular in two areas: the freedom and encouragement it gives to innovation and risk-taking entrepreneurial activity generally, and the discipline that drives up efficiency and drives down costs.

The former is stimulated most during the cyclical upswing, and the latter is compelled most during the downswing. It is at least arguable that if economies moved in a straight line rather than a cyclical pattern, there might, in the long run, be less of both these benefits of the capitalist market system. However, whether that is so or not is academic, for the cycle is ineradicable.

Yet despite all this, the focus of economic debate in this country, and I suspect in most other developed countries, is almost exclusively on the short-term vagaries of the business cycle, about which policy-makers can in reality do very little, rather than on the conditions for improved performance over the longer term, about which, both nationally and internationally, much can be done.

There are, I suspect, three principal reasons for this extraordinarily perverse paradox. The first — and I list them in no particular order of importance — is the legacy of Keynesianism. Keynes himself, writing in the mid-1930s, was of course concerned less with the avoidance of cycles than with the avoidance of slumps, which he mistakenly believed to be almost the natural condition of free economies. Hence, for example, Keynes's statement in the General Theory that:

"The right remedy for the trade cycle is not to be found in

abolishing booms and thus keeping us permanently in a

semi-slump; but in abolishing slumps and thus keeping us

permanently in a quasi-boom."

But it is not hard to see how, when Keynesianism came to be put into practice, in conditions far removed from those of slump and the 1930s, it readily degenerated into an obsession with the cycle as such, often with inflationary consequences — not least in the UK, where at one point during the late 1970s the annual rate of inflation reached 25 per cent. And even if we have, through bitter experience, succeeded in inoculating ourselves against the inflationary aspects of Keynesianism, the short-term preoccupation with the cycle is as great as it has ever been.

The second reason for the paradox may be, as I have already discussed, the passionate desire of the economics profession to believe that everything that matters can be reduced to mathematical equations and numbers. Since this cannot be done with any remote degree of plausibility for the Nature and Causes of the Wealth of Nations, Adam Smith's subject matter must clearly be far less important than the dissection of the business cycle, which so readily lends itself to mathematical and numerical analysis.

And the third reason for the paradox is, of course, the short time-horizon of the financial markets, of the media, and all too often of governments faced with the problem of re-election. Moreover change, however healthy, is always unsettling; and there is always popular pressure to prevent it.

For all these reasons, the cycle is perhaps bound to loom large. But whatever the reasons for the perverse focus on what economic policy-makers cannot achieve at the expense of what they can, does this matter?

I believe it does. It matters in political terms that the public are systematically miseducated on a matter as important as this is. And it is clearly a debasement of democracy if governments are to be elected or ejected largely on the basis of the particular phase of the inescapable economic cycle at the time an election is held.

But it matters in economic terms, too. I have little doubt that perpetuation of the notion that the cycle can be avoided or that "boom and bust" can be abolished — what might be described as the myth of the straight line — is in practice likely to lead the cycle to be more pronounced than it might otherwise have been. For the ever-present awareness that we live, as we always have done, in a cyclical world, could do more than anything else to prevent the excesses of optimism and pessimism that play such a large part in the cycle, and in so doing reduce the severity of the cycle itself.

Certainly, recent events suggest that the longer the cycle is suppressed the more damaging are the eventual consequences. Moreover, obsession with mitigating the vagaries of the cycle can all too easily lead those responsible for the conduct of economic policy to devote far less attention than they should to those issues, both at the national and the international level, that really will affect the prosperity of the people over the longer term.

But, it may be argued, can we not both have our cake and eat it? What possible harm could be done by delaying the required fiscal consolidation until the economy is stronger? In the real world, the answer is "a great deal".

First, in the words of Sir Alan Budd, the founding director of the independent Office of Budget Responsibility, "We have not yet brought forecasting and economic management to the level at which one can safely use changes in fiscal policy as a short-term method of adjusting demand."

Nor shall we ever do so, partly because of the inescapable delays and variable time-lags inherent in the system in the real world, and partly because of the irreducible unpredictability of human behaviour. There are also, of course, considerable time-lags in securing the beneficial results of fiscal consolidation. But in the conduct of economic policy, as in public policy more generally, impatience is the worst counsellor.

Second, the policies needed to eliminate the structural deficit are inevitably painful and thus unpopular. If a new government, for whatever reason, shrinks from introducing them at the outset, when its authority is greatest, the likelihood of its doing so on an adequate scale subsequently is greatly diminished.

Third, the financial markets, from whom the government is obliged to borrow, are well aware of this, and will exact a higher price. (Experience also shows, incidentally, the tendency as time passes for spending ministers to go native, and put the departmental interest above the general good. That is one reason why regular cabinet reshuffles are necessary.)

And fourth, one of the problems of democracy is the tendency of public expenditure to rise faster than is consistent with maximising economic performance and living standards over the longer term. The more that budgetary discipline is eroded, the more this is likely to happen. It is not without interest, too, that of all the major economies it was the UK that recovered fastest from the slump of the 1930s, and that it did so on a policy of cheap money and balanced budgets. In short, Keynesian stabilisation policy does a great deal more harm than good, and so does not make sense.

Myth No.5

So to the last of my five myths, one which is causing considerable angst at the present time — as indeed it did when I was Chancellor in the 1980s — and was one of the preoccupations of November's meeting of the G20 finance ministers in Korea.

This is the view that the very substantial current account imbalances that exist in the world are both unnatural and a threat to global economic health.

In the 1980s, the problem, agonised over at the IMF and wherever finance ministers and heads of government met, was the Japanese current-account surplus. Today, it is the even larger Chinese surplus — which, incidentally, although massive, appears already to be on a declining trend as a share of GDP. The first thing to be said is that, in a world in which there is, happily, freedom of capital movements, it would be extraordinary and wholly unnatural if there were not current account imbalances.

For since the overall balance of payments must necessarily balance, if there were to be no current account imbalances there would have to be no capital account imbalances, either. In other words, for each country, capital inflows and capital outflows would need to be precisely the same — a most implausible scenario.

We are living now in what might be termed the second coming of globalisation, the creation to a considerable extent of a single world economy — the first coming having been the remarkably successful half-century between the end of the American Civil War and the outbreak of the First World War, which sadly put an end to it: a period justly dubbed la belle époque.

During that happy and successful period, nobody lost any sleep over the current account of the balance of payments, not least because the figures did not exist. But it is clear from the huge amount of overseas investment that occurred, notably from the UK and some other European countries into both North and South America, that the current imbalances must have been substantial and persistent.

My good friend Robert Skidelsky, who has written a very much longer life of Keynes than my old tutor Roy Harrod, argues that the difference is that the earlier imbalances were thoroughly sound, as they were the counterpart of the richer countries of the world investing in the poorer countries; whereas today it is a case of a poorer country, China, investing in a richer country, the United States, which he terms "perverse", and thus apparently alarming.

But there is nothing "perverse" about it. Capital flows across the exchanges, which largely determine the current imbalances, have little or nothing to do with relative wealth. What they do reflect is the pattern of savings and investment opportunities around the world. There are indeed huge investment opportunities in China, as there are in the United States, too. But whereas Americans have a highly developed consumer culture, and a disinclination to save, China is at a stage in its remarkable economic development where savings have grown and continue to grow massively, in line with the growth of the economy as a whole, but a consumer culture has yet to develop.

Hence, the Chinese savings surplus which spills abroad. Perhaps a homely domestic example might help. In the old days when house purchase in the UK was financed by building societies, far and away the largest building society in the country was based not in London but in Halifax — now alas simply the "H" in the failed Lloyds HBOS banking group. This was not because the people of Yorkshire were richer than the people of London and the South of England: quite the reverse. But Yorkshire people saved, while southerners borrowed and spent. So the Halifax Building Society came to dominate the UK housing finance market by channelling savings from the poorer North to the richer South. That this was not a flow across the exchanges is beside the point.

The huge Chinese savings surplus has been exacerbated both by the great disparity of wealth between the masses and the rich, and by the absence of what we would consider an adequate social safety net. In time, this is likely to change, if only because the Chinese authorities are increasingly fearful of social unrest, and in time a consumer culture will gradually develop, as it did in Japan, despite the Japanese policy of subsidising small savings — perhaps starting with overseas tourism, as occurred with Japan.

But it would be surprising if substantial imbalances did not persist for a considerable time. For it to be an object of policy to eliminate them would be absurd. It is true that it would be highly desirable if China could find the courage and confidence to allow its exchange rate to float, if only in a managed way. But even if it did, there would still be substantial imbalances. It would also, incidentally, be sensible for China to invest its surplus savings more in productive assets around the world and less in Treasury bills and the like, as in time the Japanese did, and as indeed the Chinese are already beginning to do. Whether this will be universally welcomed is another matter. But that should not prove an insuperable obstacle.

In short, the bottom line is that the so-called imbalances are a fact of economic life in a globalised world economy, rather than a dangerous defect that has to be remedied.

The Menace

But there is a menace stalking the planet at the present time, which we do need to take very seriously indeed, because the matter is an urgent one. It is a menace intimately linked to the last of my five myths. The architects of the post-war economic settlement rightly recognised that the disastrous slump of the early 1930s had been substantially prolonged and intensified by the beggar-my-neighbour protectionist policies indulged in, to a greater or lesser extent, by all the major world economies.

As a result, while controls on international capital movements were regarded (for too long, in my judgment) as acceptable, there was agreement that postwar reconstruction and prosperity must be based on a firm rejection of protection and the promotion of free trade — one of the core messages, of course, of Adam Smith.

This was formally institutionalised by the setting up of the GATT in 1949, forerunner of today's WTO, and was part of the DNA of the Bretton Woods institutions, the IMF and the World Bank, that had been set up four years earlier. And this proved as successful as anything ever is in the flawed world in which we live. Indeed, the two decades preceding the world recession of 2008-09, ushered in by what I have described as the second coming of globalisation, were the most successful period the global economy has ever known.

But memories are short; and — particularly, but not exclusively, in the United States — there is now a recrudescence of protectionist sentiment that threatens to repeat the disaster of the 1930s. The events of 9/11, while they shocked the world, were particularly shattering in the United States, not simply because they occurred there, but because they destroyed America's unique sense of invulnerability. In much the same way, the fact that the world recession has hit the United States particularly hard, largely because of its massive and still unresolved housing market disaster, while the Chinese economy continues to power ahead, has shattered America's economic self-confidence.

The disastrously mistaken view that China's economic progress must be at America's expense has taken root to the point where the House of Representatives has already passed a Bill to impose discriminatory tariffs against imports from China, and the Senate is widely expected to follow suit.

Moreover, this dangerous course has gained the public support of prominent US political economists who ought to know better. I refer not just to the usual partisan suspects such as Paul Krugman. Even Fred Bergsten, the founding Director of the influential Washington-based Petersen Institute for International Economics, dedicated to open world trade, whom I have known since he was a junior US Treasury minister in the Carter administration, has — regrettably — come out publicly in support of the House's protectionist Bill.

We have, of course, been here before. In the wake of President Reagan's triumphant re-election in 1984, the dollar soared even further on the foreign exchanges, and Japanese imports flooded in ever-greater quantities into the United States, causing distress among a swathe of US manufacturing industries and an upsurge of protectionist legislation in the Congress. Following the recession of the early 1980s, US unemployment in 1982 and 1983 had risen to the level it stands at today — a whisker under 10 per cent — and although it started to fall in 1984, business confidence was still distinctly fragile. (The 1980s were to prove, incidentally, the culminating decade of the seemingly unstoppable Japanese economic miracle. But no one foresaw that at the time.)

As regularly as the Bills came to him for the necessary Presidential signature, Reagan vetoed them. I recall his pointing out that he was old enough to remember the protectionist Smoot-Hawley legislation of the 1930s, and the great damage this had done. He was determined to prevent a repetition. The problem was that, with protectionist sentiment in the Congress growing ever stronger, a Bill might be passed by a two-thirds majority, which the President would then have been obliged to sign. This was the origin of the historic G5 Plaza agreement of September 1985, of which I am now one of the only two surviving participants — the other being its principal architect, the then US Treasury Secretary, Jim Baker.

Baker's overriding purpose, as he made clear to me, was to achieve something that might silence the protectionist lobby in the United States sufficiently to avoid the threat of protectionist legislation which the President would have been constitutionally unable to veto. And this was indeed achieved, by a perhaps unnecessarily prolix G5 accord whose two principal components were an agreement by the Japanese to let the yen appreciate against the dollar and a resolute rejection of protectionism in any shape or form.

Today, the task is more difficult. The G5's de facto successor, the G20, is too large and unwieldy a body to act with the decisiveness of the G5. And Japan then was, for obvious reasons, more susceptible to international, and in particular US, pressure than China is today. But that must be the G20's overriding task.

And while its recent meeting in Korea achieved relatively little, what it did achieve was better than nothing. Although it contained a fair amount of nonsense about "maintaining current account imbalances at sustainable levels", it firmly rejected the absurd US proposal that there should be fixed numerical limits on the size of such imbalances.

On the exchange rate front, the explicit commitment both to move towards "more market-determined" exchange rates and to refrain from competitive devaluation is clearly welcome, albeit that it remains to be seen if fine words are matched, in China and the US alike, by deeds. But most important was the unqualified pledge to "refrain from introducing, and oppose, protectionist trade actions in all forms".

There must be no backsliding on this in any shape or form. In particular, the overriding task of President Obama is to rise to the level of statesmanship shown by Ronald Reagan a generation ago. The pressures on him are considerable. Unable to fulfil even a small fraction of the excessive expectations that were vested in him when he was first elected, he finds himself unfairly blamed for the weak state of the US economy today, as the recent mid-term election results demonstrated. He is vulnerable to criticism on many other counts; but not that.

It is understandable that he, and his party, should seek a scapegoat; and that scapegoat is China. But this would be a route to disaster, as much for the United States as for the rest of the world. As competitive devaluation proves self-defeating, the imposition of trade barriers against China would almost inevitably lead to a worldwide downward spiral of retaliation and counter-retaliation. It is of the first importance that President Obama resists the protectionist pressures emanating from Congress and elsewhere in the US, and instead emulates the responsibility and statesmanship shown by his great predecessor, Ronald Reagan.

In conclusion, I am a cautious optimist. The world is now emerging from the worst recession since the war — indeed, the worst since the 1930s — but it is doing so in pretty good shape. This is thanks to the continuing strong growth of much (although not all) of the developing world, notably the two Asian giants, China and India. As a result, hundreds of millions of people are at long last emerging from the direst poverty, and all the ills that poverty brings — preventable disease, malnutrition, and premature death. That is wonderful news for them; but it is also good news for the rest of us.

To coin a phrase, we are all in this together. The only threat is the menace of a retreat into protectionism, and the snuffing out of the second coming of globalisation, as the First World War snuffed out its first coming. Our leaders must not allow that to happen.

So let me end, as I began, with Adam Smith. To be precise, with Walter Bagehot's eloquent essay on Smith, written in 1876, to mark the centenary of the publication of the Wealth of Nations. It was by no means wholly uncritical. But it ended in these terms:

So long as the doctrines of Protectionism exist — and they seem likely to do so, as human interests are what they are and human nature is what it is — Adam Smith will always be quoted as the great authority on Anti-Protectionism — as the man who first told the world the truth so that the world could learn and believe it.

We ignore that truth today at our very great peril.